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Despite massive improvements in productivity due to technology advances, the E&P industry has averaged a disappointing 7% return on net assets (less than its cost of capital). Its market capitalization relative to the S&P 500, even at recent high oil and gas prices, is about half what it was a decade ago. A small scale, very simple case study suggests that at least part of the reason for this disappointing performance lies in the conventional way that the industry allocates capital and selects portfolios of projects. Conventional ranking of projects by deterministic estimates of value significantly overstates value, understates risk, and misallocates capital by incurring unnecessary, uncompensated risks. Suggestions for improvements in the project selection/capital allocation prices are offered.
Petroleum exploration and production is enjoying a "golden age" in technology. Over the past two decades, finding costs have fallen more than three fold and lifting costs by half or better (EIA, 1998). Three-D seismic has improved exploration success rates by as much as 90% and development success rates by 30% (Bohi, 1997). Yet, at the same time, the return on net assets by the largest U.S. based companies in the E&P sector has averaged 7% for both integrated majors and large independents (Figure 1, Simpson et al., 1999). This return is the result of projects selected because they all exceeded the minimum estimated internal rate of return "hurdle rates", generally set at 15% or more, and were all financed with capital that generally cost in the range of 10 - 12%. This would appear to indicate long-term destruction of shareholder value.
Investors have noted these discouraging results and have responded accordingly. Figure 2 illustrates the AMEX Oil Index (16 major and independent U.S.-traded companies) and the Standard and Poors (S&P) 500 Index (the largest 500 U.S.-traded, non-financial companies, of which many of the oil companies are a subset) since January of 1990. The two indices show a continuing and accelerating divergence. Almost any major equity index other than the S&P would show an even greater divergence with the oil index.
Some would argue that this was a period of volatile and often low oil prices. To examine if price variation accounts for the divergence, the Oil Index was "normalized" relative to the larger market for equities by dividing both by their 1990 values and then dividing the normalized oil index by the normalized S&P 500. If the two indexes moved together, the ratio would remain constant at unity. This normalized value is plotted against inflation-adjusted "real" oil prices (West Texas Intermediate in 2000 dollars) in Figure 3.
In January of 1990, oil prices in real terms were about where they were in June of 2000. The Gulf War caused a price "spike" to nearly $45/b (in 2000 dollars) in October, and, as a result, oil company stock prices rose about 10% more than the full market during the late summer and early autumn, followed by a steady decline in both relative share prices and oil prices. Over the period 1991 to 1997, oil prices ranged between $16 and $26/b, but share prices gradually drifted from about 80% of comparable index stocks to 70%. In 1998 began a collapse of oil prices to nearly $11/b in December 1998 before recovering to around $30 in the spring of 2000. During this latest oil price cycle, oil company shares have held constant at about 50% of their value in 1990 relative to the market value of the full S&P Index.
An interpretation of these data is that, despite significant technological advances, the E&P industry's performance over a sustained period has been such as to erode shareholder value and the confidence. Stock prices today are about half what they were a decade ago when adjusted for oil prices and the general market trend. Such a loss in investor confidence could have devastating consequences in the future for this capital-intensive industry.
The industries interest in formal Decision and Risk Assessment (D&RA), including portfolio optimization, over the last few years has been quite amazing and somewhat surprising. Overcoming the barriers to adoption of these methods, including cultural change, continue to amaze even the most devout practitioners. Whether the drivers for accepting change emanate from the changing business climate that has been motivating recent mergers, political risks, a historical record of underperformance or just continued evolution of business practices, the desired objective remains the same - making good investment decisions.
The growing popularity of D&RA - as indicated by the number of SPE sponsored forums and ATWs, alliances and industry courses on the subject and the general uptake of the language, like P10 and P90 - support the increasing awareness of D&RA methods as a mechanism for improving industry performance. The underperformance of petroleum stocks relative to the entire stock market has been cited by several to justify the even greater adoption of D&RA methods. Though artificial bubbles in telecommunications, dotcoms, and energy trading certainly explains part of the underperformance of traditional industry stocks, like petroleum, serious questions remain about the industries' ability to actually achieve the performance in its investments that is promises in its evaluations. The gap between the promises and performances and possible causes for the gap form the foundation of this paper.
As demonstrated by Campbell, Bratvold and Begg,1 trying to address complex portfolio issues with approximations may significantly overstate returns and mislead investors into selecting projects and portfolios that fail to deliver the promised performance. In this paper we are extending this work by pursuing the basic question of the impact of individual and corporate risk attitudes in the context of portfolio selections.
We begin by briefly reviewing the basic approach to efficient frontier optimization for portfolio selection. The concept of utility is introduced and it's application for portfolio level decision is discussed. We then introduce the concept of indifference curves which, in combination with efficient frontier optimization, provides an elegant approach for identifying the optimal portfolio for a risk averse corporation.
As in Campbell et al,1 we are addressing the portfolio selection issue with the intent of emphasizing that trying to address complex issues with a na ve or poor understanding of the impact of individual or corporate reaction to risk, may lead to overoptimistic expectations and subsequent failures to deliver on commitments.
Budget Allocation Decisions
Allocating shareholder capital across projects constitutes one of senior management's principal responsibilities and is a major budgeting decision. Budgeting decisions also occur at an asset level where there is a need to allocate capital or operational resources amongst a number of competing activities.
To create shareholder value, management invests capital in a portfolio of projects that generates returns that exceed the firm's cost of capital. Oil and gas investment returns, however, are highly uncertain. Unique, diversifiable risks disrupt cash flow, depress share prices, and compromise a company's ability to invest in the future. However, traditional capital-allocation techniques leave management blind to risk by focusing exclusively on return. By contrast, portfolio theory illuminates the tradeoffs between risk and return - tradeoffs that remain hidden when traditional techniques are used. By creating a series of portfolios that minimize risk for different levels of return, portfolio theory allows management to see how different projects drive portfolio-level risk and whether incremental expected return justifies incremental risk. By explicitly addressing risk throughout the portfolio-selection process, management can answer such basic questions as, "What is the likelihood that the company can achieve its key goals".
Costa Lima, G.A. (Institute of Geosciences and Center of Petroleum Studies/State University of Campinas) | Suslick, S.B. (Institute of Geosciences and Center of Petroleum Studies/State University of Campinas) | Schiozer, R.F. (FGV-SP and Center of Petroleum Studies - State University of Campinas) | Repsold, H. (PETROBRAS S/A) | Filho, F. Nepomuceno (PETROBRAS S/A)
This paper (73141) was revised for publication from paper SPE 63056, first presented at the 2000 SPE Annual Technical Conference and Exhibition held in Dallas, Texas, 1–4 October 2000.
Despite massive improvements in productivity due to technology advances, the E&P industry has averaged a disappointing 7% return on net assets over the last decade (less than its cost of capital). Its market capitalization relative to the S&P 500, even at recent high oil and gas prices, is about half what it was a decade ago. A small-scale, very simple case study suggests that at least part of the reason for this disappointing perform-ance lies in the way that the industry conventionally allocates capital and selects portfolios of projects. Ranking of projects by deterministic estimates of value and even some of the so-called advanced methods significantly overstates value, understates risk, and misallocates capital by incurring unnecessary, uncompensated risks. Suggestions for improvements in the project selection/capital allocation prices are offered.
Petroleum exploration and production is enjoying a "golden age" in technology. Over the past two decades, finding costs have fallen more than threefold and lifting costs by half or better (EIA, 1998). Three-dimensional seismic has improved exploration success rates by as much as 90% and development success rates by 30% (Bohi, 1997). Yet, at the same time, the return on net assets by the largest U.S.-based companies in the E&P sector has averaged 7% for both integrated majors and large independents. (Original analysis based on Simpson et al., 1999). This return is the result of projects selected because they all exceeded the minimum estimated internal rate of return "hurdle rates," generally set at 15% or more, and were all financed with capital that generally costs in the range of 9-12% or more. This would appear to indicate long-term destruction of shareholder value. The recent period of high oil and gas prices has ameliorated these results but not enough to offset the long-term trend.
Investors have noted these discouraging results and have responded accordingly. Relative to the Standard & Poor's 500 Index (the largest 500 U.S.-traded, nonfinancial companies), the Amex Oil Index (the 16 largest U.S.-traded oil companies) has fallen 50% between January 1990 and October 2000. This reflects real value loss relative to alternative directly comparable investments.
This paper was prepared for presentation at the 1999 SPE Annual Technical Conference and Exhibition held in Houston, Texas, 3-6 October 1999.